Consumer lending: Loans secured against tax refund? Someone thought it was a good idea

It's an idea that developed in the USA amongst, mainly, small banks with customers in the SME and individual sectors. The concept is simple: if tax has been overpaid, then the business or family has no access to that money until the IRS sends it back. When money's tight, then any short term boost to cashflow is attractive. Or so it first appears.

But when FDIC looked at the loans, it found that they cost consumers more than other forms of borrowing - and that the loans were also a higher-risk for the banks because the value of the security depended on the quality of the tax advice and the veracity of the information as well as the determination by the IRS - it was possible, FDIC found, that the banks would be holding "security" that turned out to be worth less than the loan.

And while memories in government tend to be short, they can still think back to the financial crisis and the problems for balance sheets of lending exceeding asset values. Indeed, with almost 40 - mostly small - banks closed by FDIC so far this year, FDIC is still dealing with those issues on a day by day basis.

FDIC has been taking action against banks offering this service for some time both in respect of "tax preparers" (a silly name: they prepare tax returns, not tax) who are directly contracted to the banks and to those who operate a panel of approved service providers.

The system included a clear conflict of interest: the tax return preparers were also brokers for the loans and therefore entitled to earn commission. As the amount of commission depended on the amount of the loan, it was in the (fraudulent) interests of the tax return preparers to inflate the amount of tax that would be refunded. Loans were made of a percentage of that amount.

FDIC's latest (and reportedly last) case of this type is in respect of Republic Bank & Trust of Kentucky, Louisville, Kentucky. FDIC has been on the bank's case for some time saying that the "RAL" service was based on unsound banking principles and breached the Truth in Lending Act.

In February this year, FDIC applied for a "cease and desist" order telling the bank to stop all RAL services. The bank, FDIC said, made more than 800,000 RALs which amounted to some USD3,000 million. Good business, some may think. Unfortunately not, says FDIC which pointed out that this amounted to, broadly, the equivalent of the bank's entire asset base. But, as the IRS - even if the figures are correct - will withhold payment if the taxpayer is in debt to the IRS or one of a number of other government departments or - even - child support. That means that even accurate calculations are no guarantee of a full refund.

The risk of such a debt-clawback was reduced by allowing banks access to a database of taxpayer's debts to government. This allowed the banks to disallow the loan to the extent that a clawback was due. But for the 2011 that access has been shut down, leaving the banks blind as to a significant lending risk.

FDIC says that it may still be possible to make RALs but only if they meet normal credit lending criteria. Republic, says FDIC, did not make that change in policy nor in the consequential underwriting.

Now FDIC is proposing that Republic be fined USD2 million for breaches of various laws and regulations.